Here’s another reason to favor energy names. The recent sharp decline in oil and energy stocks is more about over-exuberant traders exiting the group than it is about fundamentals, says Will Riley, who helps manage the Guinness Atkinson Global Energy Fund
GAGEX, -1.05%
He thinks oil could rise 5% to 10% over the next one to two years.

Leaning against the crowd often makes sense in the market, and that’s what you’re doing if you bet that oil prices will go higher.

“There are still a lot of people who don’t believe it because they have been fed nothing but negative news for three years,” says Mike Breard, an energy sector analyst at Hodges Capital Management. In other words, oil, and oil stocks, are climbing the proverbial wall of worry.

The bullish demand-supply fundamentals are still intact, and ultimately that is what will prevail. Let’s take a quick tour.

The demand side

The International Energy Agency (IEA) is predicting an extra 1.4 million barrels per day in demand in 2018. (For context, the world uses about 98 million barrels a day.) But this estimate, which plays a big role in creating the consensus outlook, may be light given the robust global economic strength.

If global GDP growth comes in at 3.9% this year, as the International Monetary Fund (IMF) forecasts, actual daily oil demand could grow more than the IEA estimates, says Riley. That matters, given the supply constraints.

The strongest demand gains come from large, high-growth emerging market economies like China and India. A big factor here is the emerging middle class. Some of the first things people do when they make more money is get wheels, use more electricity and take more trips by airplane.

The supply side

The rap on the Organization of the Petroleum Exporting Countries (OPEC) is that they are a bunch of cheats. They set production targets, and then break them on the sly to make more money. But this isn’t always the case. Right now, OPEC compliance with production cuts has been very good, says Riley. A key factor here is Saudi Arabia, which wants a solid floor under oil prices to support the partial floatation of its giant oil company, Saudi Aramco. This is a big component of the country’s experiment with diversifying away from oil. The Saudi’s don’t want to flub the floatation.

Next, U.S. production growth will likely be less dramatic than expected. The consensus fear is that U.S. shale producers will once again greedily ramp up production sharply — and shoot themselves in the feet by killing off oil-price gains. This probably won’t happen, for these reasons.

First, a common theme at energy conferences now is that shale producers want to attract and maintain a stable shareholder base. To do so, they’re pledging to avoid overspending their cash flow and borrowing too much. “It’s different this time” are the scariest words in investing. But things might really be different this time in the oil patch.

Here’s why. The last time U.S. producers ramped up debt and production, oil prices plunged as Saudis retaliated with a flood of supply. Many U.S. companies had a near-death experience they don’t want to repeat.

“There will be better capital discipline,” predicts Riley. “Permian producers say they will ramp up more gradually.” One obstacle is a shortage of skilled workers. “There is a real labor crunch in the Permian basin,” says Breard. “It is not as easy to get a fracking crew as it was last year.”

Another factor limiting global oil supply growth is the underinvestment by the majors in long-term projects. They’ve held back during the past few years because oil prices were so low and the oil outlook so bleak. Now the chickens are coming home to roost.

This third bucket of supply — or the non-OPEC and non-U.S. oil projects in places like the North Sea, Brazil and West Africa — is important because it makes up about half of world supply. These projects take around four years to develop. So the projects that the majors started balking on in 2014 would have started kicking in this year. They won’t. Since world production naturally declines, this “lost” production will hurt supply growth for at least the next three or four years — the number of years producers have been on an investment strike, so far.

Energy companies to consider

• Halcón Resources
HK, +0.56%
is a rapid-growth Permian play with a strong balance sheet and low valuation favored by Steven Schuster, at Bridge Street Asset Management. He thinks Halcón stock is being temporarily suppressed by selling from Franklin Templeton Investments, which got stock converted from debt in a recent bankruptcy reorganization. Schuster is worth listening to because his two picks from my August 2017 energy sector column, Hi Crush Partners
HCLP, +1.29%
and U.S. Silica Holdings
SLCA, +1.96%
were up 61% and 31% as of the end of January. For context, the stocks in the column as a group were up 28.5% and XLE was up 18.6%, as the S&P 500 rose 16.8%.

• Gulfport Energy
GPOR, +1.64%
is another favorite of Schuster’s. This is a play on natural gas (NG), which is out of favor as an investment play right now. Investors believe that shale oil produces so much natural gas as a byproduct, NG prices will struggle to move higher. But inventories are 16% below the five-year average, which could drive NG prices higher at some point. Gulfport Energy trades at multi-year lows and half of book value. It’s buying back stock and planning asset sales to fund more buybacks.

• Matador Resources
MTDR, +2.93%
is up 34% since Breard, at Hodges Capital Management, suggested it in my energy column last August (performance as of the end of January), nicely beating the column average and the XLE. But he still likes this mid-cap exploration and production company with holdings in the Eagle Ford shale, the Permian Basin and the Haynesville shale. “Matador is one of the best operators,” says Breard. “When they drill a well, it generally produces more and costs less compared to competitors’ wells nearby.” The company also has energy-processing plants and pipelines it might spin off, which could add $5-$10 in per share value for investors, says Breard.

• Propetro Holding
PUMP, +0.87%
an oilfield-services company that came public about a year ago, is another favorite of Breard’s. It’s a natural play on U.S. shale production growth since it specializes in helping oil companies with fracking right in the sweet spot — or the Permian Basin. Propetro has a reputation as a high-quality and reliable services provider, says Breard. So it can pick and choose among customers to work with the most efficient companies — and avoid inadvertent downtime. Third-quarter sales growth came in at 32% and cash flow grew 56%. Propetro is fully booked through the end of this year, and it is adding production fleets.

• National Oilwell Varco
NOV, +1.06%
which supplies rig equipment like specialized tools, pipes and well casings, is a favorite of Colin McWey who helps manage the Heartland Mid-Cap Value
HRMDX, -0.52%
Investors are worried about National Oilwell Varco because of the downturn in demand for offshore rigs, and the decrease in U.S. onshore rig growth because of better shale-production efficiency. But McWey, a value investor and a contrarian, thinks these fears are overstated because National Oilwell Varco cut costs by so much during the recent sector downturn.

“They have gotten leaner and meaner,” says McWey, whose fund beats competing funds by 1.3 percentage points, annualized, over the past three years, according to Morningstar. “In the middle of the next up cycle, they can get close to prior levels of profitability even if the rig count does not get up to where it was.”

At the time of publication, Michael Brush owned HK and MTDR. Brush has suggested HK and MTDR in his stock newsletter Brush Up on Stocks. Brush is a Manhattan-based financial writer who has covered business for the New York Times and The Economist group, and he attended Columbia Business School in the Knight-Bagehot program.

Michael
Brush

Michael Brush is a Manhattan-based financial writer who publishes the stock newsletter Brush Up on Stocks. Brush has covered business for the New York Times and The Economist group. He attended Columbia Business School in the Knight-Bagehot program.

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